Financial Times
December 15, 2004
The dollar's renewed decline in recent months has increased concerns about how far and how fast the adjustment will go. While the International Monetary Fund has warned for some time of the dangers posed by global current account imbalances, it is important not to be alarmist.
The dollar has depreciated significantly since early 2002 and is now much closer to equilibrium than then. However, it is quite far from its all-time lows. It traded significantly lower in the mid-1990s against the group of currencies that formed the euro. And in real terms the dollar is still well above the levels it reached against the yen just a few years ago, let alone in the early 1990s.
Rapid dollar depreciation is a concern, but the recent decline is best seen as a wake-up call for governments to take the policy actions needed to tackle global imbalances and to strengthen their own economies. The main elements of this global strategy are steps that are clearly in the self-interest of individual countries: increased saving in the US, stronger domestically driven growth in Europe and Japan and more exchange rate flexibility in China and some other Asian emerging market countries.
Some people have argued that a further large dollar depreciation is inevitable if the US current account is to adjust without a significant fall-off in growth. That is, if the US is to reduce spending on foreign goods significantly without a recession-inducing reduction in spending on domestic goods, the latter have to become relatively much cheaper. Hence the necessity for a further large real depreciation.
Of course, if markets thought such a large depreciation were certain, it would happen in short order, with all the attendant costs of an abrupt, disorderly move. But a large move is not inevitable, for two main reasons.
First, the goal is not to have the US reach current account balance but to reduce the deficit to a level that is sustainable in the medium term. Our calculations show that the US, with its higher productivity growth and younger population, can sustain a deficit of 2-3 per cent of gross domestic product. This means the US needs to cut today's deficit of about 5 1/2 per cent of GDP by about 3 percentage points, with corresponding adjustment among the surplus countries.
Second, given the right policies, and flexibility, the supply side will respond to the depreciation that has occurred. But do we have time? This depends on how long the US current account deficit will continue to be financed in an orderly way. In short, it depends on the attitudes of foreign private investors, who still finance more of US needs than foreign official investors. For private investors the primary focus is expected return on investment.
If investors see a credible set of policies in place that will narrow imbalances, they will understand that the necessary further dollar depreciation will be relatively small, and they will be willing to hold US financial assets. Otherwise, they will be more inclined to place their funds elsewhere. Paradoxically, this would force more rapid adjustment, with interest rates in the US surging up to attract back foreign investors and the exchange rate depreciating more than necessary so that the expected appreciation will give investors reason to return to the dollar. Such forced adjustment would entail more depreciation, more dislocation and slower growth.
Policymakers should avoid playing the blame game, which is a recipe for inaction: global imbalances are a problem of global disequilibrium, and it is unproductive to point to one or other localised variable - saving here or investment there - and pin the entire blame on it. It is actions that matter.
The IMF's advice is clear. In the US, credible measures of fiscal consolidation are needed, together with measures to boost private saving. The eurozone and Japan must concentrate on structural reforms to increase flexibility and to boost domestic demand and growth, especially in the relatively inefficient non-traded sectors. Meanwhile, emerging Asia should allow greater exchange rate flexibility and focus on reforming the financial sector. The first will help to cool overheating economies; the second will increase the level and quality of investment while reducing the need for saving.
The big players have signed up to these policies, as shown in various communiqués. But now action is needed. Spelling out adjustment plans will help, as will a timeframe where appropriate. But up-front measures will have special value. An important source of credibility - in part because of the associated peer pressure and monitoring - can be explicit mutual commitments made through international policy agreements.
Otherwise, the outlook could well worsen. If the markets continue to doubt the resolve of policymakers, investors may not wait around long enough for promises to be kept. For the sake of the world economy, we need action.